For two years, market observers have been predicting a recession. Why? They’ve pointed to what’s known as an inverted yield curve—when short-term interest rates are higher than long-term rates. Historically, this has been a bad omen for the economy, and that’s why investors have been worried. The yield curve has been inverted since 2022. Despite that, the economy has remained strong, and markets have continued to reach new highs.
That all changed last Friday, when a little-known indicator known as the Sahm rule began flashing red. In general terms, this rule says that when the unemployment rate begins to increase at a particular rate, a recession is likely. Among economic indicators, the Sahm rule is relatively new, but in back-testing, it’s been shown to be remarkably accurate. Since 1959, it would have generated just two false positives.
That’s why it caused alarm last week when the government released employment figures for July. The unemployment rate rose unexpectedly, exceeding the Sahm rule’s threshold. The result was an immediate sell-off in markets around the world. In the U.S., stocks dropped 1.8% last Friday and another 3% on Monday. International markets fared worse. In Japan, the Nikkei index dropped more than 12% Monday, its worst single-day loss since 1987.
But despite the Sahm rule’s nearly unblemished track record, its creator, Claudia Sahm, was quick to step in with a cautionary word. “We are not in a recession now—contrary to the historical signal from the Sahm rule…A recession is not inevitable.” Despite the Sahm rule’s accuracy, in other words, Sahm herself is telling investors not to worry.
What can we conclude from this seeming contradiction? For starters, economists tell us that—alarming as they are—we should actually worry less about sudden market crashes than about conditions that deteriorate slowly. That’s because sudden crashes tend to be overreactions. One bad data point, like last week’s jobs report, is just that—just one data point. And no one should draw a conclusion from such limited information. In contrast, when the market drops steadily over time, that’s usually in response to a series of consistently negative data points. That’s when we should really worry. As a result, and counterintuitively, sharp and brief drops shouldn’t rattle us.
Another reason sudden drops shouldn’t scare us: the presence of computer-driven trading. While it’s hard to quantify, some large portion of daily trading is driven by algorithms that seek out trends, then place short-term trades to profit from them. The result is that small market moves can turn into big ones, but only for technical reasons. The magnitude of market drops, in other words, isn’t entirely a representation of investors’ opinion of current events—which itself may not be completely rational.
Sometimes there’s a domino effect behind a market decline that is even more difficult to see. Careful observers, in fact, have pointed out that the decline began last Thursday—a day before the unemployment numbers were released. The proximate cause: The Bank of Japan unexpectedly lifted interest rates. That caused the Japanese yen to appreciate, and that, in turn, stressed investors who had borrowed money in yen (because it would then be more expensive to repay those loans). Some feel that this set the stage for the drop on Friday, but if it did, it was only from a mindset point of view. Japan’s rate move had nothing to do with the unemployment report in the U.S. the next day. But because they occurred nearly in unison, it gave the misleading appearance that the jobs report was more serious than it actually was.
Intuition tells us that the best move in situations like this is to sit tight, to remain invested and to avoid getting swept up in other investors’ fears. But it’s not just intuition. The data is clear on this point. Looking at market downturns in the past 30 years, an investor would have been better off, on average, with a simple buy-and-hold strategy rather than selling investments in an effort to avoid further losses.
The past week provides a perfect case in point. Over the course of this week, the S&P 500 has recouped more than half of its earlier losses. And with today’s gains, it’s on track to recover further.
Another reason to avoid overreacting to individual data points is that data often contains noise. Writing in late-July, Claudia Sahm noted how some of these distortions were affecting her indicator. “The Sahm rule is likely overstating the labor market’s weakening due to unusual shifts in labor supply caused by the pandemic and immigration,” she wrote, adding that it’s important for investors “to look under the hood” at what’s behind the data. Creators of other well-known metrics have similarly cautioned investors. William Sharpe, for example, father of the Sharpe ratio, has talked about how easy it would be to manipulate his ratio into generating virtually any answer.
There’s an old New Yorker cartoon that shows a man watching the evening news. The reporter delivers this market summary:
“On Wall Street today, news of lower interest rates sent the stock market up, but the expectation that these rates would be inflationary sent the market down, until the realization that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to a reimposition of higher rates.”
This is amusing but not far off from reality. Are we heading into a recession? It’s certainly possible, but just as the economy has defied economic indicators for the past two years, it might continue to do so. That’s why investors’ best bet, in my view, is to develop an investment plan that can carry them through any market environment without the use of a crystal ball.
